Are Financial Markets Too Complacent About the Global Economy?

The latest polling suggests the British are inclined to drop out of the European Union, throwing the future of the world’s largest trading bloc into doubt.

The United States in November may elect a president who promises to abandon many norms of governance, and a horrendous terrorist attack has opened up new talk in the presidential race of upending the nation’s longstanding economic and diplomatic relationships with the rest of the world.

Oh, and last month the United States experienced its weakest job growth in six years.

If there was a good time for financial markets to show signs of fear for global economic and political stability, this would seem to be it.

In the last several days there has been some evidence, if you look carefully enough, of the risk that some big, disruptive events will become priced into markets. The British pound has fallen steeply on currency markets, reflecting the risk of “Brexit,” and government bond prices in advanced nations have soared (and their yields have fallen) as investors have plowed money into safe assets.

But many other financial market conditions are more consistent with what you expect to see when everything is basically going fine — not indicative of a major risk of financial, economic or geopolitical upheaval.

The American stock market, as measured by the Standard & Poor’s 500 index, is hovering just below record highs. A measure of expected market volatility, the Vix, has spiked in the last few days but remains well below its level of just a few months ago. Oil prices have been rising steadily since February and haven’t moved much in the last week, let alone shown the drop you might expect if a collapse in global demand seemed imminent.

There are two possibilities of what is going on. At best, the markets are telling us something important that excitable journalists and pundits aren’t. Call this the markets-are-smart theory.

At worst, markets are complacent, and deep-seated flaws in how financial markets work mean that current stock and commodity prices aren’t reflecting the major risks that lie ahead.

The “markets are really efficient” story goes like this: Britain, when all is said and done, will probably vote to remain part of Europe (as betting markets suggest). Donald Trump probably won’t be elected president (as polling suggests). The American economy will probably keep doing O.K. despite the weak May jobs numbers.

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A sign in the sidewalk outside the New York Stock Exchange.CreditStan Honda/Agence France-Presse — Getty Images

And even if any of those forecasts turns out to be wrong, the consequences for the economy and corporate profits won’t be as severe as fearful headlines suggest. The British economy will remain basically sound as the nation renegotiates its trade relationships; Mr. Trump will govern more like a conventional president than his words now suggest; and any economic slump in the United States will be short and mild.

In this story, stock, bond and currency traders have the wisdom to look past the noise that the aforementioned excitable journalists and pundits don’t.

The other argument is scarier.

Markets are very good at incorporating news into asset prices when it’s clear and straightforward how one should affect the other. When a company releases an earnings report, analysts can quickly figure out what it should mean for the stock price, and the stock moves accordingly. When data comes out that makes a Federal Reserve rate increase 10 percent more likely, it’s fairly straightforward to translate that into the proper pricing of Treasury bonds and the dollar. A disruption to an oil pipeline has a relatively clear-cut impact on the price of crude.

So traders are efficient at pricing in pieces of news that affect asset prices in predictable ways over the short and medium term. They’re a lot worse at predicting which major threats to the global economy will spiral out of control and which will turn out to hardly matter.

Consider two examples from recent years.

In the summer and fall of 2011, investors were panicked that the eurozone would unravel because of the fiscal crisis that started in Greece. Global stock markets, commodities and risky forms of debt plummeted; volatility skyrocketed.

But things turned out to be more or less fine. More aggressive action by the European Central Bank and European political leaders starting late that year helped calm everyone. And while the European economy is not in great shape, the Continent experienced no epic financial crisis. If you had the nerve to buy eurozone stocks in September 2011, you have enjoyed a 51 percent return on your money.

Other times, instead of being too fearful of cataclysmic events, financial markets are too complacent. What we now call the global financial crisis got its start in mid-2007, as losses on mortgage-related securities mounted and global money markets froze up.

But after some initial efforts by the Federal Reserve and other government officials to contain the damage, financial markets rallied 11 percent from mid-August through mid-October, pushing the stock market to new highs and suggesting all was well. Of course, as it turned out, a severe recession and catastrophic financial crisis were just around the corner. People who bought into any risky assets, whether stocks or mortgage-backed securities, at the October highs lost their shirts.

Some smart people, like strategists at Goldman Sachs, are advancing the possibility that markets could be in a similarly precarious state right now. It may even be that the normal mechanisms through which those fears would translate into lower stock prices and higher volatility indexes are broken right now; many “macro” hedge funds that bet on big seismic changes in the global economy have been losing money for the last few years, and some have closed.

Even if that’s so, the next few months will be a great test of just how much markets really know about the future. And given the precarious headlines of the last few months, anyone who wants to make sure they don’t lose their shirts again should hope that they’ve got it right.